4 Stocks to Navigate Challenges in the U.S. Upstream Industry

Despite escalating geopolitical risks, concerns over global demand have offset any price support, which, in turn, has affected the Zacks Oil and Gas – Exploration and Production – United States industry.  The Fed’s emphasis that there was no urgency to reduce rates, citing robust inflation and economic indicators observed since the year’s commencement, adds to concerns. The market hasn’t been kind to natural gas either, with the commodity continuing to trade under $2. Although macro challenges are leading to some demand concerns, we think the space still has fuel left in the tank, especially for the operators that target growth opportunities and operating efficiency initiatives. We advise investors to focus on Diamondback Energy FANG, Coterra Energy CTRA, APA Corporation APA and Magnolia Oil & Gas MGY.

The Zacks Oil and Gas – US E&P industry consists of companies primarily based in the domestic market, focused on the exploration and production (E&P) of oil and natural gas. These firms find hydrocarbon reservoirs, drill oil and gas wells, and produce and sell these materials to be refined later into products such as gasoline, fuel oil, distillate, etc. The economics of oil and gas supply and demand are the fundamental drivers of this industry. In particular, a producer’s cash flow is primarily determined by the realized commodity prices. In fact, all E&P companies’ results are vulnerable to historically volatile prices in the energy markets. A change in realizations affects their returns and causes them to alter their production growth rates. The E&P operators are also exposed to exploration risks where drilling results are comparatively uncertain.

3 Key Trends to Watch in the Oil and Gas – US E&P Industry

Fed’s Hawkish Stance, High Production Roil Oil, Gas: WTI crude, the U.S. benchmark, has been under pressure of late. The shift came after the release of hawkish Federal Reserve meeting minutes and cautious remarks from several Fed officials, dampening expectations of interest rate cuts that could stimulate energy demand. The central bank emphasized a cautious approach, citing stronger-than-expected inflation and economic data in the year. Additionally, another increase in domestic crude stocks was recorded, coupled with low refinery activities, while production remained steady near a record 13.3 million barrels per day. Concerns over prolonged high interest rates from the Federal Reserve overshadowed gradually rising geopolitical tensions, particularly in the Middle East and kept the commodity from moving into the $80s. Shifting focus to natural gas, the commodity, which had slumped to a 25-year low in June 2020 but reached $10 per MMBtu in August 2022, is now trading below $2. This decline is attributed to heightened production levels and predictions of lackluster weather-related demand.

Focused on Cost-Cutting Initiatives: The energy companies have changed their approach to spending capital. Over the past few years, producers have worked tirelessly to cut costs to a bare minimum and look for innovative ways to churn out more oil and gas. And they managed to do just that by improving drilling techniques and extracting favorable terms from the beleaguered service providers. Moreover, driven by operational efficiencies, most E&P operators have been able to reduce unit costs, while the coronavirus-induced collapse in crude forced them to adopt a more disciplined approach to spending capital. These actions are expected to preserve cash flow and support balance sheet strength.

Concerns About Supply-Chain Tightness: Most energy companies (including the upstream operators) have been experiencing rising costs in the form of increased expenses related to maintenance and inventory. Despite moderating from record levels, inflation in the United States remains above the threshold levels. This, together with supply-chain tightness, is not only pushing costs higher but also affecting capital programs. Apart from being hard to ignore, escalation in expenses is also drowning out the benefits of any commodity price increase. In our view, the inflation-associated headwinds will continue to challenge growth and margin numbers with little chance of a quick resolution. This may lead to a rough road for oil/gas equities engaged in energy exploration and production.

Zacks Industry Rank Indicates Bearish Outlook

The Zacks Oil and Gas – US E&P industry is a 38-stock group within the broader Zacks Oil – Energy sector. The industry currently carries a Zacks Industry Rank #240, which places it in the bottom 4% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates challenging near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s position in the bottom 50% of the Zacks-ranked industries is a result of a negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are becoming pessimistic about this group’s earnings growth potential. As a matter of fact, the industry’s earnings estimates for 2024 have gone down 39.5% in the past year.

Despite the dim near-term prospects of the industry, we will present a few stocks that you may want to consider for your portfolio. But it’s worth taking a look at the industry’s shareholder returns and current valuation first.

Industry Underperforms S&P 500 & Sector

The Zacks Oil and Gas – US E&P industry has fared worse than the Zacks S&P 500 composite as well as the broader Zacks Oil – Energy sector over the past year.

The industry has edged up 0.1% over this period compared with the broader sector’s increase of 0.9%. Meanwhile, the S&P 500 has gained 27.5%.

Industry’s Current Valuation

Since oil and gas companies are debt-laden, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because the valuation metric takes into account not just equity but also the level of debt. For capital-intensive companies, EV/EBITDA is a better valuation metric because it is not influenced by changing capital structures and ignores the effect of noncash expenses.

On the basis of the trailing 12-month enterprise value-to-EBITDA (EV/EBITDA), the industry is currently trading at 7.03X, significantly lower than the S&P 500’s 14.1X. It is, however, above the sector’s trailing 12-month EV/EBITDA of 3.71X.

Over the past five years, the industry has traded as high as 12.49X, as low as 3.57X, with a median of 6.24X.

4 Stocks to Watch

Diamondback Energy: Diamondback Energy focuses on growth through a combination of acquisitions and active drilling in the lucrative Permian Basin spread over west Texas and New Mexico. While many companies employ a similar strategy, a few have been as successful as Diamondback. The upstream company has consistently posted some of the strongest operational and financial results among the independent producers. With an attractive production profile, favorable industry trends and low breakeven economics, the margin of safety on investment is very high.

This Zacks Rank #3 (Hold) upstream firm’s expected EPS growth rate for three to five years is currently 21.9%, which compares favorably with the industry’s growth rate of 21.2%. FANG shares have gained 26.3% in a year. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.Coterra Energy: Coterra Energy is an upstream player with a high-quality, multi-basin portfolio boasting top-tier assets and a deep drilling inventory. The wells drilled by Coterra Energy have extremely low breakeven costs and need oil prices of just $50 and natural gas at $2.50 to be profitable. The company’s balance sheet is also fortified with strong liquidity and minimal debt, while it returns any excess cash to shareholders through dividends and buybacks.

Carrying a Zacks Rank #1, Coterra Energy’s expected EPS growth rate for three to five years is currently 55%, which compares favorably with the industry’s growth rate of 21.2%. CTRA shares have gained 4% in a year.

APA Corporation: APA’s large, geographically diversified reserve base and high-quality drilling inventory should guarantee multi-year production growth. The company’s increased focus on the Permian basin, known for its low cost and high internal rates of return, is another key driver. APA’s slew of discoveries in offshore Suriname, through its joint venture with TotalEnergies, is another positive catalyst for the company. Over time, Suriname is expected to become one of APA’s major assets with significant cash flow potential.

APA beat the Zacks Consensus Estimate for earnings in three of the last four quarters and missed in the other. The company delivered a trailing four-quarter earnings surprise of roughly 14.2% on average. APA currently carries a Zacks Rank of 3. The energy explorer’s shares have lost 21.3% in a year.

Magnolia Oil & Gas: Magnolia Oil & Gas is an independent exploration and production operator, with the Eagle Ford Shale and Austin Chalk formations in South Texas being its chief operating regions. The company focuses on growth through a combination of acquisitions and active drilling. In fact, MGY’s high-quality acreage resulted in a 9.3% average production growth last year. Further, Magnolia has done a commendable job of enhancing its unit metrics, leading to attractive margins. MGY is also financially healthy, with modest debt and solid liquidity.

The 2024 Zacks Consensus Estimate for MGY indicates 3.9% year-over-year earnings per share growth. The Zacks Rank #3 company delivered a trailing four-quarter earnings surprise of roughly 0.6%, on average. Magnolia Oil & Gas’ shares have gained 1.4% in a year.

Source: finance.yahoo.com